Last month we looked at the latest risk-reducing measure brought in as part of the European Market Infrastructure Regulation (EMIR). This month we return to look at MiFIR and the trading obligations covering derivatives and, in particular, shares and what impact these will have on investors and investment firms alike.
Trading obligations require that shares and certain derivatives are traded under the rules of trading venues rather than over the counter (OTC). The aim is to standardise the market and increase transparency for investors as to price formation and volumes.
Looking first at shares, the regulation1 requires that shares that are admitted to trading on an EU venue are traded on regulated markets (RM), multilateral trading facilities (MTF) or a systematic internaliser (SI). There exist exemptions where the trade is ad hoc and infrequent or the trade is between professional or eligible counterparties and does not contribute to the price discovery process, but other share transactions should be completed on a venue. Venues already process billions of share transactions every month with the ‘real’ number of OTC equity transactions put anywhere between 10% and 40% depending on how the calculation is made. In its report three years after the implementation of MiFID I it was estimated by the Association for Financial Markets in Europe (AFME) that 16% was the most likely OTC market share.2 The trading obligation is therefore aimed at these 16% and to push those trades onto a venue. The share trading obligation is live from 3 January 2018.
The trading obligation for derivatives is distinct and different from the one applying to shares. Products have to pass a two-stage test: firstly, the product must be subject to the EMIR clearing requirements and, secondly, the European Securities and Markets Authority (ESMA) must have declared the product subject to the trading obligation. The significant difference to the share trading obligation is that the derivative trading obligation cannot be fulfilled by using a SI but has to be traded under the rules of a RM, MTF or an organised trading facility (OTF). The only products that are subject to the clearing obligation at this time are certain interest rate swaps and index credit default swaps for major European indices. While under the regulatory technical standards proposed by ESMA, the derivatives trading obligation could come into force already from day one of MiFIR, at least for the largest financial counterparties. The remainder of this article will focus on the trading obligation for shares which is effective from 3 January 2018 onward, and likely to affect a much larger group of counterparties.
Investors used to trading their shares OTC direct with market participants may find that those avenues are closed with firms unable to operate within the exemptions outlined above post-January 2018. Consequently, investors would be forced to trade on a venue whether through a broker or some other intermediary, likely incurring higher costs than before. These additional costs are likely to be an unintended consequence of the drive for transparency and will likely leave investors frustrated.
However, a potential solution exists for investors concerned, there will be additional fees associated with on-venue trading in the form of trading with counterparties who are SI for the shares in question. We have discussed SI and their critical role in the MiFID II transparency regime, but they also offer an attractive option in relation to venue trading.
In practice, SI have been in the market since MiFID I, where they were limited to shares. ESMA currently has 12 market participants listed as SI, but under MiFID II that number is expected to grow substantially as the product scope has widened. The requirement for shares is that SIs stream firm prices up to a standard market size which is expected to be retail size (approximately EUR 10,000).
This requirement to provide pre-trade transparency on shares means that there will be a significant number of quotes in themarket for shares, all being published by an approved publication arrangement3 (APA). With so many quotes it is likely to push business on to SI due to them providing not only a potentially better price for investors but also giving significant market transparency for what is occurring away from the traditional venues.
Add to this the emergence of smart order routers looking to ensure best execution for undirected orders as well as clients seeking out best execution desks, the share trading universe is likely to get significantly more competitive. In turn, this is likely to tighten spreads as SI compete with each other as well as RM and MTFs. The winners will be investors trading the smaller tickets (i.e. below the standard market size) and taking advantage of these firm quotes in the market.
In addition to the price benefits smaller investment firms will also be relieved to be free from the post-trade transparency requirements falling on them as the SI would instead be liable for that reporting. As post-trade transparency for shares would need to be reported within one minute smaller investment firms have long been worried about the costs of implementing that reporting. Consequently, by trading shares with a SI you get the benefits of trading outside the traditional venues without additional reporting requirements.
The SI regime offers an interesting solution to the share trading obligation as well as to post-trade transparency requirements under MiFID II, and clients would be wise to ascertain who in their current trading universe intends to be a systematic internaliser. Clients can leverage this offering and potentially reduce not only their trading costs but also provide certainty for their reporting obligations which would cut down on infrastructure expenditure significantly.
It’s guaranteed to be a challenging time for investors and market participants from January 2018 with such a large regulation coming into force; and getting clarity on how they will trade simple products such as shares post go-live should be one of the first things that clients should be looking to confirm. Processes for the derivatives trading obligation though will likely have to follow a different approach as the SI option is not available there.
1 Article 23 MiFIR.
2 AFME, ‘The Nature and Scale of OTC Equity Trading Europe’, April 2011.
3 An approved publication arrangement (APA) is a person authorised under the provisions established in the MiFID II Directive to provide the service of publishing trade reports on behalf of investment firms (Article (4)(1)(52) MiFID II). APAs are designed to provide services to an investment firm in order for it to meet its obligations under Articles 20 and 21 MiFIR.